Irrevocable Transfer Agent Instruction Letters: Critical Questions

Perhaps no type of transaction results in more heartburn to a microcap CFO than the ubiquitous Convertible Note and its accompanying irrevocable transfer agent instruction letter.

Short on funding options from more traditional sources, many microcaps resort to convertible notes. In such transactions, the noteholder offers desperately needed capital in exchange for a Convertible Promissory Note. Accepting the funds, the issuer satisfies its immediate cash flow demands and survives to fight another day. But then it comes time to pay the piper.

Typically, once the note has “aged” in accordance with Rule 144, the debt can be converted into common stock at a steep discount and immediately sold in the marketplace (assuming all requirements of a Rule 144 resale has been met). The aggressive sale generally causes the stock price of the thinly traded microcap to drop, and each subsequent conversion request is computed at a lower stock price resulting in the issuance of more and more shares.

The stock price plummets, the float explodes, and the debt becomes harder and harder to pay off. It is the ultimate Death Spiral. It harms real investors. And yet, it is the only way some microcaps can obtain critical funding.

Some noteholders take advantage of a struggling issuer’s need for immediate funding, crafting irrevocable transfer agent instruction letters that exclusively serve their own interests while restricting the issuer’s ability to take any meaningful defensive steps to prevent an abusive death spiral. They will note release funding without the issuer and transfer agent’s consent to the irrevocable instruction letter.

If you are considering funding via a convertible note with a requisite irrevocable instruction letter, consider the following critical questions first:

  • Can you pay off the note in cash? If so, what is the penalty for prepayment?
  • Does the note contain any backend agreements or obligation to issue additional securities other than the promissory note?
  • Is the calculation of the conversion ratio clear, objective, and easily understandable?
  • Do you have the right to dispute a conversion request?
  • Who is responsible for the issuance and transfer fees, you or the noteholder?
  • Does the agreement restrict your ability to change transfer agents without the noteholder’s consent?
  • Does the agreement restrict your ability to enter funding agreements with other parties?
  • Does the share reserve auto-renew, or does it decrease with each conversion request?
  • What steps must be taken to cancel or reduce a share reserve?
  • Is there a limitation on the number of conversion requests that can be presented in a given period or the number of shares that can be requested for each conversion?
  • Can the note be sold to another party?
  • Do other issuers offer positive reviews concerning working with this noteholder?
  • Are there outstanding lawsuits, judgments, or active investigations against this Noteholder or any other entities under common management or control?

As a transfer agent, ClearTrust has encountered hundreds of convertible notes and irrevocable transfer agent letters. We have the benefit of difficult experiences and active industry involvement to know what to look out for and how to better protect issuers and shareholders against egregious noteholders. Contact us for assistance: 813-235-4490 or kara@cleartrusttransfer.com.